Stock market: Should investors fear a correction, or 10 percent drop?

Bear Market is a term that sends fear into Wall Street and investors. What does it mean? And how does it affect both Wall Street and Main Street? Adam Shell explains.

A screen above the floor of the New York Stock Exchange shows the closing number of the Dow Jones industrial average, Wednesday, Oct. 10, 2018. The Dow Jones Industrial Average plunged more than 800 points, its worst drop in eight months, led by sharp declines in technology stocks. (AP Photo/Richard Drew) ORG XMIT: NYRD111(Photo: Richard Drew, AP)

There's nothing more unnerving to stock investors than watching the market go down day after day.

Headlines about 600-point drops in the Dow Jones industrial average and pessimistic pundits predicting more declines have become more frequent in October. The big price declines and shrinking account balances are making investors queasy and prompting them to wonder if the money they have in the market and their 401(k) retirement plans are safe.

But the severity of any market drop on Wall Street needs to be put into the proper perspective – especially in a wild up-and-down environment like now when the Dow can fall 600 points in a single day, like it did Wednesday, only to rebound 400 points the next day, as it did Thursday.

Wall Street professionals use three measurements to define the intensity of a market drop from a recent high.

The three main descriptions of down markets are: a "pullback," or drop of 5 percent to 9.99 percent; a "correction," a decline of 10 percent to 19.99 percent; and the feared "bear market," or 20-percent-plus drop.

"It's like turbulence on an airplane," says Joe Quinlan, chief market strategist at U.S. Trust. "(A pullback) is hardly noticeable, (a correction) is annoying and worrisome, and a (bear market) is truly frightening."

After Wednesday's big selloff, the magnitude of the market's decline shifted closer to the "worrisome" category. Both indexes inched dangerously close to correction territory. Heading into Thursday's trading session, the S&P 500 was 9.4 percent below its Sept. 20 all-time closing high, and the Dow was down 8.4 percent from its Oct. 3 record.

But Thursday's big rebound rally, which pushed the Dow up 1.6 percent to 24,985 and the S&P 500 up 1.9 percent to 2706, enabled both indexes to climb back into positive territory for the year and dodge the dreaded 10 percent drop – at least for now.

Pullback: first sign of trouble

Pullbacks, or dips of less than 10 percent, are normal periods of adjustment that get the attention of investors, many who had gotten too complacent. These drops, which often begin without warning, tend to be short-lived, however. And they normally aren't disruptive enough to change the market's longer-term rise.

The Dow, for example, has suffered 395 dips of 5 percent or more since 1900, according to Alan Skrainka, chief investment officer at Cornerstone Wealth Management. That equates to roughly three pullbacks a year. The recent slide marks the second pullback of 2018.

And when it comes to losses, the average pullback for the S&P 500 since World War II has averaged 7 percent and lasted about a month, according to data from CFRA, a Wall Street research firm. Historically, it has taken about six weeks to recoup pullback losses.

At its low point Wednesday, the current downturn's 9.4 percent fall, therefore, is worse than average. . The sharp, swift decline has been sparked by fears that growth of the U.S. economy and corporate earnings will start to slow due to trade disputes and slowing growth in China, the world's second-largest economy.

Correction: 10 percent drop piques fear

Corrections are more serious market declines that kick in when the market suffers a 10 percent drop. Unlike pullbacks, however, corrections do more damage and last longer. In the 22 corrections in the post-war era, the S&P 500 suffered an average loss of 13.8 percent and dragged on for 148 days, or roughly five months, according to CFRA. After hitting a low, it takes the market about four months, on average, to get back to even.

A good example of a scary correction that did not morph into a bear market was the 10.2 percent decline that ended in early February. The S&P 500 recouped its losses in late August and went on to make a record high a month later.

Still, the greater severity of these losses tend to boost fears on Wall Street of a more serious coming decline, says Bruce Bittles, chief investment strategist at investment firm Baird. If the current pullback morphs into a full-blown correction, it would be the second of the year.

"The question is: Does it lead to a bear market?" asks Bittles.

Corrections often intensify when fear levels rise on Wall Street and panicky investors sell to avoid even bigger losses, which exacerbates the downward pressure on prices. The market's situation often becomes more precarious when closely watched indexes like the S&P 500 sink below key levels that investors viewed as floors, or areas of support.

On Wednesday, for example, the S&P 500's downward spiral picked up steam after it was unable to stay above the 2710 level, its low from a selloff earlier this month. Similarly, the large company stock index's dive below its average price over the past 200 trading days also spooked investors, as it signals that the market's trend may be shifting from up to down.

What makes a correction "trickier" for investors to navigate is the fear that prices can fall a lot more "before stabilizing," says Nick Sargen, chief economist and senior investment advisor for Fort Washington Investment Advisors. "Selling also breeds more selling," he adds.

Not knowing if the double-digit percentage decline will get worse or prove to be a buying opportunity creates uncertainty for investors.

Bear Market: Wall Street's most feared decline

Bear markets, or drops of 20 percent or more, are feared by investors. The reason: They tend to erase a large chunk of the gains from the prior bull market, which results in huge losses for individual investors. The current bull run, which began in March 2009 and is the longest in history, registered a gain of 333 percent as of its recent record high on Sept. 20.

The average loss in bear markets dating to the Great Depression is nearly 40 percent, according to S&P Dow Jones Indices. But the past two bear markets, including the one caused by the banking crisis that ended in March 2009 and the 2000-02 tech-stock meltdown, wiped out half of the market's value.

Stock prices in bears, on average, tend to slide for 21 months, or nearly two years, before hitting a bottom, data show.

If a bear drop of 20 percent occurs, it would slice a $100,000 investment in the S&P 500 at last month's high down to $80,000.

Brutal bear markets are normally caused by wildly overvalued markets like tech stocks in 2000, or shocks such as the OPEC oil embargo in the mid-1970s, or financial crises like the mortgage meltdown in 2008 that cause massive damage to the banking sector.

Bear markets also occur when the U.S. economy suffers a recession. Currently there are no signs of recession.

"A bear market is scary because the market decline is typically swift, and it's difficult to time when to get out," says Sargen.

To survive periods of market turbulence, Skrainka says it is imperative that investors have the right mix of investments that they can stick with in "good times and bad." In short, make sure your portfolio wasn't too risky for you to handle.

Other survival tips include maintaining a long-term perspective, making sure your portfolio is diversified and is filled with shares of quality companies that have a history of surviving difficult times.

"Most people buy when they feel good and the news is good; this is when prices are higher and future returns are lower," Skrainka says. "Market declines can be the long-term investor's best friend because they offer the opportunity to buy good investments at a lower price."